New York March 12 2025: Moody’s changed Banking System Outlook for Pakistan to positive from stable on better operating environment.
“We have changed our outlook on Pakistan’s banking system to positive from stable to reflect the banks’ resilient financial performance as well as improving macroeconomic conditions from very weak levels a year ago” states Moody’s report.
“The positive outlook on the sector also mirrors the Government of Pakistan’s (Caa2 positive) positive outlook, with Pakistani banks having significant exposure to the sovereign through their large holdings of government securities, which account for around half of total banking assets. However, Pakistan’s long-term debt sustainability remains a key risk, with its still very weak fiscal position, high liquidity and external vulnerability risks” the report added.
We expect the Pakistani economy to expand by 3% in 2025, compared with 2.5% in 2024 and -0.2% in 2023. Inflation is also significantly easing, which we estimated at around 8% for 2025 from an average of 23% in 2024. Problem loan formation will slow as borrowing costs and inflation reduce, although net interest margins will narrow on the back of interest rate cuts. Banks will maintain adequate capital buffers, supported by subdued loan growth and solid cash generation, despite dividend payouts remaining high.
Outlook changed to positive from stable on better operating environment
Better operating conditions will support Pakistani banks: Pakistan’s economic outlook is improving from very weak levels, with enhanced government liquidity and external positions compared to 2024. The sovereign’s 37-month $7 billion IMF Extended Fund Facility approved in September 2024 provides a credible source of external financing for Pakistan for the next few years. We forecast GDP growth of 3% in 2025 and 4% in 2026, up from 2.5% in 2024, further driven by a 10 percentage point cut in interest rates since the start of the monetary policy easing cycle in June 2024. . We expect inflation to slow sharply to around 8% in 2025, from
an average of 23.4% in 2024. We expect that lower inflation and policy rate cuts will spur private-sector spending and investment in Pakistan from current low levels.
High exposure to government securities raises asset risk: As of September 2024, government securities accounted for 55% of banks’ total assets. This significant exposure links banks’ credit strength to that of the sovereign, which is improving from very weak levels. Although problem loans have deteriorated to 8.4% of total loans as of September 2024 from 7.6% in the prior year, overall loans account for only 23% of banks’ total assets. In 2024, banks have increased lending to private businesses to meet regulatory ADR requirements , with loans, excluding government, growing by around 5% in the year to September 2024 compared with the same
period in 2023. With the removal of ADR tax for 2025, we expect lower pressure on banks to increase financing, while demand remains relatively subdued despite lower borrowing costs. Authorities continue to implement measures to boost SME financing, which we expect will drive low-single digit lending growth in 2025. Although operating conditions are improving, we expect the lagged effect of very high inflation in 2024, combined with still elevated interest rates, to drive additional problem loan formation. However, modest loan growth will keep problem loans at around 9% of gross loans.
Profitability will moderate as rates decline, but remain sound: Margins will narrow following recent interest rate cuts that have reduced the policy rate to 12%. Pakistani banks derive the bulk of their earnings from the interest they receive on large investments in government securities, which are yielding lower returns compared with last year. Concurrently, downward asset repricing will only be partly offset by lower funding costs, while growth in business activity and non-interest income will not fully counterbalance margin compression. A potential deterioration in the loan book would push provisioning costs up from low levels, while lower inflation will reduce the strain on operating costs. The impact from the recent removal of the ADR tax will be offset by the subsequent increase in corporate tax rate to 44% from the previous 39%. We expect banks’ return on assets to moderate to around 0.9%-1.0% in 2025.
Capital will remain broadly stable: Strong profitability coupled with low credit growth in 2023 and 2024 have boosted Pakistani banks’ capital buffers. Tier 1 Capital and total capital to risk-weighted assets (RWAs) ratios for the system improved to 17% and 21.5% respectively as of September 2024 from 16% and 19.7% as at the end of 2023. Our capital metric, tangible common equity to adjusted RWAs ratio, is a low 4.1%.4Problem loans are fully covered by loan loss reserves (112% coverage for rated banks), providing additional capital protection. Although margins are likely to narrow, we expect capitalisation to remain broadly stable over the next 12 to 18 months, supported by modest growth in RWAs.
Funding and liquidity are supportive: Enhanced financial inclusion and remittances from nonresident Pakistanis continue to boost domestic deposit inflows, which fund bank lending. Customer deposits remain the main source of bank funding, accounting for 60% of total assets as of September 2024. Although the market funding to tangible assets ratio is elevated at 41.9% as of September 2024, this is mainly short-term interbank funds and collateralised borrowing from the State Bank of Pakistan (SBP) to invest in government securities. Banks’ reliance on market funding is limited, with a system ADR ratio of 36.3% in September 2024 (50.4% in 2022) and they will continue to hold sufficient liquid assets to meet any unexpected outflows. However, we estimate that around 40% of banks’ holdings in government securities are encumbered, held as collateral with the central bank. Foreign-exchange (FX) risks have reduced in response to a rise in SBP’s FX reserves since the unlocking of the IMF program.
The government’s ability and willingness to support banks in case of need is improving: Pakistani banks play a crucial role in supporting government spending, with commercial bank borrowing totalling around Rs8.475tn between July 2023 and June 2024. The government’s capacity to support failing banks is improving, although from a relatively weak position, as indicated by the upgrade on the sovereign rating and positive outlook.
